Friday, August 6, 2010

Fuck The Deficit (Or Will The Deficit End Up Fucking Us?)

Currently, the United States is conducting one of the most remarkable experiments in fiscal finances in world history.

The American economy is in a severe recession. Coupled with that—as both partial cause and partial effect of the recession—the United States' banking system crashed in the Fall of '08, a crash which in many ways is still ongoing as I write this, nearly two years later.

What the recession and the concomitant banking crisis have caused are, essentially, a fall in aggregate demand levels, as well as a fall in aggregate asset value. In other words, the population is spending less, and asset values have deteriorated, both nominally and as compared to any basket of hard commodities.

These are the two metrics which the two principal camps of current American macroeconomic thought consider vital. “Saltwater” economists look to aggregate demand levels, while “freshwater” economists look to aggregate asset value—each of these camps view their fetish-object as the cornerstone for economic growth, development and prosperity. Naturally, when either of these camps see their juju slide, they freak out. They declare the economy to be “in crisis”—and further declare that “something must be done”.

Something has been done: It's called The Deficit.

To combat the fall in aggregate demand levels, the Federal Government has embarked on a massive spending program. This spending program has been financed by debt issued by the Treasury. The way things are looking, another big spending package is in the offing some time soon—that should keep the “saltwaters” happy.

On the other hand, to combat the fall in aggregate asset value—and keep the “freshwaters” happy—the Federal Reserve Board has embarked on an asset purchase program that is also massive and unprecedented. Through a fairly complex scheme that seems to be deliberately opaque, the Fed has relieved the Too Big To Fail banks of their deteriorated assets, and given them cash, in an ongoing process. The Too Big To Fail banks have turned around and used that cash to purchase Treasury bonds—which are being used to finance this massive Federal Government spending. Whether there has been collusion between the Treasury, the Fed and the TBTF banks is for the courts and the historians to decide—but prima facie, it would certainly look so.

This two-sided scheme—more Federal Government spending on the one hand, and more propping up of asset values on the other—adds up to The Deficit.

When I refer to it as The Deficit (it is too majestic for the lowercase), I am not referring to a mere fiscal shortfall—I am referring to a policy mentality. This policy mentality—shared by both “saltwater” and “freshwater” economists—effectively amounts to a suspension of the notion of opportunity cost. In the realm of The Deficit, the macroeconomic policy questions cease to be “either/or”—they become “both/and”. All policy options can be achieved because—according to the macroeconomic policy known as The Deficit—the American fiscal shortfall can never bring the United States to bankruptcy. As Dick Cheney so memorably phrased it, deficits don’t matter—so The Deficit as a macroeconomic policy can continue indefinitely.

In a historical sense, The Deficit is unprecedented: Never before in world history has a reserve currency provider gone into this much debt, with a currency that floats on nothing but air. This is the key issue: The dollar is a fiat currency. The Roman, French, British, Austro-Hungarian empires, all of them world-historical empires in their times, all might have gone way into the red on more than one occasion—but none has ever done it on a purely fiat currency before.

America is the first to do so (“U!! S!! A!! WE’RE!! NUMBER!! ONE!!”). Hooray.

The Deficit is the policy that the United States is implementing, and it has had several effects:

1. The most obvious, it has allowed the Federal Government to finance every last one of its spending programs, in an effort to boost aggregate demand levels. No need for Obama’s vaunted talk of “tough choices”—the Federal Government has officially been renamed the Great American Teet.

2. It has prevented the TBTF banks from acknowledging the plain fact that they are broke. Indeed, the Fed asset buy-back has effectively kept the banks solvent in a practical sense—they have money to pay off any of their liabilities. But more importantly from the Fed's point of view, it has sustained deteriorated aggregate asset values in the overall economy, at least on a nominal basis.

3. It has created a fiscal shortfall of staggering proportions—currently about 100% of GDP, and growing without end.

4. Finally—and most importantly—it has created the generalized impression among policy makers that fiscal shortfalls indeed do not matter, and that liquidity and stimulus simply mustbe provided whenever there is a crisis, the rationale being that the economy is too “fragile” to withstand the “shock”.

This is a key effect of this policy, I would argue the most important of all of the effects: The fact that the fiscal shortfall has crossed the 100% of GDP mark, and nothing bad has happened has given everyone a false sense of security—the sky has not fallen, the world has not ended.

Therefore, as a practical political matter, the people with decision-making authority in American public policy have effectively said, “Fuck The Deficit, let’s keep on truckin’.”

But what if the sky does fall? What if we are simply living in the lull before the fall? I mean, it can't be that this enormous fiscal shortfall can continue growing indefinitely, can it? It has to lead to some kind of ruinous effect, right? Like drinking a bottle of scotch in a single sitting—you feel good while you're doing it, sure, but you know you’ll feel like death warmed over soon enough, right?

I mean, The Deficit will eventually come back and bite us on the ass—right?

Lately, there have been an awful lot of clever people explaining how, in fact, The Deficit will not harm us in the long term.

Very sensible-sounding words, and seemingly-sophisticated arguments, are deployed to make precisely this point. Others further argue that The Deficit, because of its sheer size, will become its own growth engine, and hence will grow the economy to such a point that The Deficit will essentially pay for itself—a bit of financial magic that almost seems believable.

And to any talk that The Deficit and the stealth-monetization going on might lead to hyperinflation, these clever people are scoffing and saying, in effect, “Haven’t you heard the news? We got deflation, pal—forget about inflation, let alone hyperinflation: We gotta spend-spend-spend, in order to whip that deflationary monkey. After that’s taken care of, and the economy’s growing again, that’s when we’ll be able to bring down The Deficit.”

Recently, I had a private exchange with a financial blogger, about precisely this point. This blogger—who should have known better—argued that since we were in a deflationary environment, there were currently no inflationary pressures, and none in the forseeable future. Therefore, she argued, since the economy was experiencing a deflationary trough and inflation highly unlikely, then hyperinflation was an impossibility. Nay, an absurdity, or so she claimed.

She's clever, but she made a common mistake—she confused inflation with hyperinflation.

Granted, they do seem to look alike—both of them are essentially money losing value against wages, commodities and goods-and-services over time. Commonly—and mistakenly—hyperinflation is viewed as simply inflation-plus, inflation-XL. After all, the name seems to imply it: Hyper-inflation. Inflation’s big brother. Inflation with an extra bit of kick.

This is a dangerous fallacy.

Inflation is indeed the economy “over-heating”, in Neo-Keynesian parlance—wage pressures, say, dragging prices up across the economy, or perhaps raw commodity prices doing the same. Inflation can gallop up to 25% a year, but still remain a distinct animal from hyperinflation. Ordinarily, inflation is simply the economy eating up commodities—be it raw materials or labor—so as to meet demand.

Hyperinflation, however, is the loss of faith in money. It is not that prices are rising because the economy is moving forward—it’s that prices are rising because nobody believes that money is worth a damn anymore.

Hyperinflation is not simply money-printing: Rather, it is when no amount of money will get you what you want. Zimbabwe-style hyperinflation is an example of government money-printing run amok. The Zimbabwe example gives us the mistaken sense that hyperinflation only happens in “disorderly printing” regimes. But that’s not the case.

Chilean hyperinflation in 1973 (which led to the September 11 coup), or Weimar style hyperinflation (which led to you-know-who), are more indicative of what I’d call “scarcity” hyperinflation: Both are examples of when the scarcity of basic commodities suddenly and abruptly leads to a complete loss of faith in money—the belief that no amount of money will get you what you want or need.

That’s hyperinflation.

2008 Deflationists (of which I am a member) argued that after the credit crisis, there would be a deflationary trough. The reasoning of the 2008 Deflationists was, credit should be considered as part of the money supply—so when credit contracts sharply, as happened following the banking crisis in ’08, then that’s the same as if total money supply had contracted. A constriction in the money supply obviously leads to deflationary pressures: Less money is available for the same or more goods. Hence prices fall to meet lowered demand. Hence wages fall as business incomes fall. Hence less money. Hence downward spiral.

As the 2008 Deflationists predicted, today the U.S. economy is in a deflationary trough—I am certainly not arguing otherwise: The evidence is all around, and too obvious.

But what I am saying is, our current deflation can trip over into hyperinflation at a moment’s notice. The stumbling block—the thing that could trip us over from deflation to hyperinflation literally overnight—is The Deficit.

Not just the Federal shortfall itself, but the policy implicitly embodied by The Deficit: The belief that all you need to do is throw money at the problem—open up as many liquidity windows as needed, or expand Federal spending as much as necessary, to prop up those twin aggregates I mentioned before, aggregate demand and aggregate asset value.

The pernicious sense among American macroeconomic policy makers that fiscal shortfalls don’t matter—and don’t matter especially in a financial or economic crisis—is what I believe will lead to hyperinflation. Policy makers—who have lost any fear of providing as much liquidity and stimulus as necessary to steamroller any problem—will have no compunction about adding to The Deficit at the next crisis.

That’s when hyperinflation will kick us in the teeth.

If I had to make a prediction, I’d say that the immediate trigger for a hyperinflationary catastrophe will be a sudden and unexpected commodity spike. It won’t necessarily be big, but it’ll be flashy—enough to cause a panic.

This will be the opening stages of hyperinflation: It will be a market panic, and it’ll be fast.

At the next panic-inducing crisis, American public-policy makers will once again turn to The Deficit, providing more liquidity and more stimulus—and this will make the financial markets realize that the fiscal shortfall is unsustainable: It will be obvious that all those Treasuries cannot be repaid—or if they are ever to be repaid, it will be done by the Fed via surreptitious monetization. In other words, a dollar with lesser value.

Thus, everyone will want to be the first to get out of the dollar—and everyone will want to be the first out the door all at once.

Markets turn on a dime, and they are not rational in the short term—they’re rational like a herd of thundering buffaloes hopped up on crystal meth.

As everyone gets out of the dollar in the financial markets, there’ll be a cascading effect, as everyone—both Wall Street sophisticates and Main Street naifs—try getting out of their dollars, and into hard assets: Gold, land, food, whatever.

In other words, hyperinflation as I have described it above: A loss of faith in money. The belief that no amount of money will buy you what you want.

The Deficit—that’s the demon’s name. The Deficit. Not, as I have argued, the fiscal shortfall, but the macroeconomic mentality that fiscal shortfalls in a reserve fiat currency do not matter. The sense that as much liquidity and stimulas must be and can be provided to maintain aggregate demand levels and aggregate asset value.

Policy makers are not exactly known for being prescient timers of the markets—at the next market crisis/panic, they will without hesitation provide stimulus and liquidity, adding even more to the fiscal shortfall. But it will be the market’s and the public’s loss of faith that that fiscal shortfall will ever be repaid that will lead them to abandon the dollar.

Once they lose faith in the dollar, hyperinflation will ensue, as public policy officials continue providing “stimulus” and “liquidity” which the market will interpret as nothing but worthless paper.

Actions have effects—it is stupid to think that massive deficit spending of a fiat currency won’t have consequences. The policy embodied by The Deficit has brought the U.S. economy to the brink of oblivion—with no way to pull back from that brink. So at this point, the only question is, what will finally tip it over, and what will give us that final push.


  1. Ummm, ok, so how do you explain away Japan? Non AAA credit rating, debt2GDP ratio much higher than the US, yet they are still a functioning society. They've been at this a lot longer than the US, yet all is "well" over there. No armageddon, no brink. The Yen? It hasn't exactly collapsed.

    Your essay reads real good. Until you apply it against empirical real world examples. Then it falls apart.

    You continue to operate under the outdated model that the deficit is what finances the operations of a sovereign nation when the deficit simply represents the shortfall in private demand that the govt must step in to fill. Armageddon will occur when they stop doing that and it's a Mad Max scenario in the streets because nothing is propping up the economy.

  2. You are right that fiat money is different. I don't think you are right about what it means.

    Check our Wynne Godley (who incidentally taught Goldman's Jan Hatzius at Cambridge: Goldman's last Macro report is pure "Sectorial Balances" which you need to understand if you want to understand the difference between commodity and fiat money) or Bill Mitchell for what fiat money really means with regards to deficits.

    Mitchell and Ed Harris both have blogs that deal quite well with the special conditions that lead to hyper inflation: they are political conditions, not economic ones when they involve a sovereign nation that issues its own fiat currency.

    And please note that Greece, Spain, Portugal, Ireland and Greece do not issue their currency. When Argentina and Mexico defaulted, like the Pacific Rim defaults ten years ago it was due to a dollar peg and dollar denominated debts.

  3. What about the $300Billion each year, in US $,
    that China gets from the American consumer?

    That huge pile of $ keeps 300M Chinese employed.

    Hence China will COOPERATE WITH THE USA, very
    tightly, to avoid 300,000,000 angry Chinse destroying big pieces of cities because the
    300,000,000 have NOTHING TO LOSE....they are starving.

  4. Twinsanity, you're making three big mistakes in your response.

    Firstly, you're flatly ignoring the "reserve currency" angle.

    Secondly, you're saying "look, look at Japan -- it hasn't happened there yet, and therefore you are wrong". The keyword there is 'yet', and I'm sure anyone acquainted with basic logic can explain why this does not constitute a rebuttal, even if conditions in Japan were the same as in the U.S., which they are not.

    Thirdly, the "outdated model that the deficit is what finances the operations of a sovereign nation" is outdated in the same sense as tie-dyed shirts or bell-bottom jeans: it isn't fashionable at the moment. But governments don't "have" to "step in". Rather, they butt in because people who are smart and overconfident in their own abilities declare that they have to.

    This has all happened before. If one's historical knowledge only involves one 1990-present in one geographical location, one is in for a big surprise.

  5. "She's clever, but she made a common mistake—she confused inflation with hyperinflation."

    My money is on Yves.

  6. I find it hard to believe that our policy makers do not understand the actions / re-actions of their monetary policies.

    Assuming they do know what they are doing, the question is why? To what ends justify these means?

    Either way, heaven help us all.

  7. Anonymous, please do not forget, though it's changing right now, that one of the world's greatest buyers of US debt is China.

  8. Gonzalo - you are right again.
    And part of the reason why is, no one wants to pay for the obvious bailout of the banksters - there will be a tax revolt when/where possible (those than can, will not pay).
    Who would pay their taxes if they could avoid doing so when this is obviously a ripoff of the middle class to bailout the elites?
    Those than can will now move their operations offshore and become a Bermuda or Hong Kong company.
    HSBC (Hong Kong Shanghai Banking Corp) was HQed in Hong Kong until the Chinese takeover of Hong Kong in 1997 whence they moved to London. Now that London is poised to set a new burdensome tax on banking ops, HSBC is looking at moving back to HKG.
    The John Galts will not pay for government foolishness!

    Best regards (and keep up the great work),
    The Navigator

  9. To twinsanity

    The difference between the Japanese and US deficit is that Japanese hold the debt..........wheras in the US it is owned by foreigners who can recall at any time since the debt is of short term duration. Incidently the UK is also running a large deficit but their bond are long term....5-7 yrs...........verses short term debt by U.S. which must be rolled over and get new debt at the same time.


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